Euro gives dollar a run for the money

ByDavid R. FrancisJanuary 8, 2007

The US dollar, as an international currency, is facing its strongest challenge in decades. Some pin-striped central bankers are diversifying modestly in their official foreign-exchange reserves – out of dollars and into euros, the common currency of 13 European nations. It's suspected that, among criminals, the 500-euro bill (worth about $660) rivals the $100 greenback as a way to sneak cash across borders.

Most experts don't foresee a dramatic shift out of the dollar. It's likely to dominate the international sphere for years, if not decades, to come.

Nonetheless, the dollar's declining value last year on foreign-exchange markets and the continuing massive US trade deficit are trampling the reputation of America's currency.

"The euro is catching up, probably very rapidly," says Peter Pietsch, an economist at Commerzbank in Frankfurt, Germany. At this time, the dollar and euro are the only two important international currencies, and they are "competing fiercely against each other."

•As of this past autumn, the value of all euro notes in circulation worldwide exceeds the value of total US currency. With each euro worth about US $1.33 on the foreign-exchange market today, the 628 billion euro notes in circulation on Dec. 22 are worth $828 billion, exceeding the $753 billion of American currency in circulation as of Dec. 18.

The European Central Bank expects the number of euros in circulation to shrink a little with the end of the Christmas demand for cash. But last week, the European Monetary Union welcomed its 13th member nation, Slovenia, the former Yugoslav republic. That adds a little to the demand for euros.

One explanation of this phenomenon is that Europeans tend to use cash more often when paying for goods and services; Americans offer credit cards.

•Seeing the dollar's decline in value – 11 percent against the euro in 2006 – some central banks and finance ministries have been diversifying their financial assets and transactions into euros.

Iran stated last month that it will use the euro instead of the greenback for its foreign-trade transactions, including oil sales. Considering Iran's political clash with the US on uranium enrichment, the news didn't surprise foreign exchange markets.

Other oil-rich nations are shifting to the euro. So is Switzerland, it's reported. The central bank of the United Arab Emirates, a close US ally, said it would convert eight percentage points of its foreign-exchange reserves into the euro. At present, some 98 percent of the UAE's $25 billion in reserves are in dollar investments.

New data from the Bank for International Settlements (BIS), an institution in Basel, Switzerland, that serves major central banks, shows that Russia and members of the Organization of the Petroleum Exporting Countries have cut their dollar holdings from 67 percent in the first quarter of 2006 to 65 percent in the second quarter. The euro's share of their overall financial holdings rose from 20 to 22 percent.

That shift may seem modest. But it reflects a change of sentiment toward the five-year-old euro in the financial world. The euro is now recognized as a solid currency, worthy of succeeding the former deutsche mark as a bastion against the depredations of inflation.

A new BIS working paper by economists Gabriele Galati and Philip Wooldridge concludes: "The liquidity and breadth of euro financial markets are fast approaching those of dollar markets, and as a result the euro is eroding some of the advantages that have historically supported the preeminence of the US dollar as a reserve currency."

Nevertheless, the dollar has maintained its place as the dominant official reserve holding of central banks. Public data on such holdings is often incomplete and secret. But the BIS paper estimates that the share of euro- denominated reserves has risen to 25 percent in 2005-06, up from 20 to 22 percent in 1995-96 for the currencies of the nations that subsequently joined the euro system.

Foreign central bankers hold dollar assets in their reserves because they can be sold easily in emergencies to defend the value of their own currencies on foreign-exchange markets. The market for dollar assets in the world's financial system is huge. Bankers aren't so troubled about whether those assets (usually short-term US Treasuries) lose value in terms of their own currencies. Finance ministries, with their political concerns, may see declining dollar assets with more distaste.

Overall, however, the US dollar lost only about 4.5 percent in value last year against a basket of foreign currencies selected and weighted by the value of US imports and exports.

Since the end of what is known as the Bretton Woods international monetary system under President Nixon, the value of the dollar on foreign-exchange markets has fluctuated. But according to one expert, the dollar's purchasing power, compared with other currencies, has changed little since 1971.

The US is the world's largest debtor nation. So when the dollar depreciates, foreigners see the value of their dollar assets decline in terms of their own currencies. They continue to be paid interest on those American debts, but they are "robbed" of some of their value, should they sell them.

Such losses worldwide could total many billions of dollars. China alone holds more than $700 billion in its reserves. A 10 percent drop in the value of the dollar against the yuan would mean a $70 billion loss for China.

The US benefits when foreigners use the dollar because Washington gets first use of that money, and after production costs, it's free, called seigniorage.

In an ideal world, says John Williamson, a veteran economist at the Peterson Institute for International Economics in Washington, there would be one international reserve currency rather than a national currency, such as the dollar, acting as an international reserve currency.

"It's not healthy for one country to have a monopoly," he says.

But Special Drawing Rights, a currency system created by the International Monetary Fund in 1969 as a substitute for the dollar and for gold, have not caught on among central bankers. They have merely a minor role in world finance today.

As for the future of the dollar, the view of economists differs.

Commerzbank's Mr. Pietsch, though seeing the euro as a continuing competitor to the dollar, expects its value to slip to $1.27 by the end of the year.

Peter Morici, an economist at the University of Maryland, College Park, maintains that the relative vitality and innovation of the American economy will limit the challenge from the euro. "The world still revolves around the US economy," he says.